GFIA examines the 'December effect' on hedge funds

Many hedge funds appear to reduce their exposure towards the end of the year, a trend that fund of hedge funds GFIA analysed in its monthly Research Insights report, published yesterday. The Singapore-based firm did so using figures from 32 Asia-based long/short equity funds.

"Given that most managers' performance fees are measured on a calendar year, exposures drop in December as managers reduce risk to protect that year's performance," says the report, which used data stretching back to 2002. "We tested that hypothesis, as well as reviewing exposures and monthly returns."

GFIA found that gross exposure of Asia ex-Japan managers is low in December and January, while net exposure is high -- suggesting that managers reduce risk overall in those months, but in particular reduce short exposure. "This is rational, as the low levels of market liquidity over the year-end in Asian markets would make short sellers particularly vulnerable to squeezes," says the firm.

As with the Asia ex-Japan funds, gross exposure for Asia including Japan funds was low in December. However, Asia including Japan funds in fact showed net exposure at its highest in that month. Moreover, the same group had the lowest gross exposure in August, a time when they also had low net exposure.

"Other than December, August has also historically been a month when markets see low levels of activity," says GFIA. But unlike in December, when funds appear to be focused on slashing short exposures, Asia including Japan funds also reduced their long exposures in August.

The one common factor among both groups of funds is that periods with higher gross exposures always corresponded with periods where net exposures were lower. This is consistent with an overall risk aversion, says GFIA, in that shorts are inherently riskier than longs, and so short exposure is often reduced disproportionately in environments of rising uncertainty -- such as a period of market illiquidity.

The firm explains that gross and net exposures of funds are among the key statistics that investors monitor on a month-to-month basis. For a long-short equity fund, in particular, these numbers go a long way towards explaining performance.

The numbers can conveniently be used as indicators of how a fund manager has positioned themselves for a particular month, adds the report. Hence, understanding the changes in exposures can provide an experienced analyst with insights as to how fund balance sheets might be managed in the future in different market environments.

GFIA plotted charts to illustrate its findings, which are provided in the December 1 report.